March 23, 2012

Matthew Yglesias: Self-Defeating Austerity

When Austerity Is Self-Defeating: [N]rmally stimulating the economy with discretionary fiscal policy won't work because the central bank, in order to avoid inflation, will respond to any stimulative impact with higher interest rates. Thus government purchases will "crowd out" private sector activities.... But in a period when rates are up against the zero bound and still the economy is depressed, the calculus is different. By simply committing to keep interest rates low despite the expansion in government debt, the central bank can allow an expansion in government purchases to increase the amount of economic activity and not just crowd out private sector investment.

But what about the need to repay the loan later with taxes? Doesn't that produce growth-slowing distortions? Yes, it does. But they argue that the decision to allow for a very prolonged period of depression also creates economic distortions. For starters, a prolonged recession means a prolonged period of time of below-average investment—a time during which population growth and depreciation mean that a society's stock of capital goods is declining. Secondarily, when people are employed they're constantly learning job-relevant skills whereas when they're unemployed they're slowly un-learning those skills....

Their net point is that rather than a tradeoff between short-term pain and long-term gain, we face a tradeoff between the long-term pain of needing to repay a larger stock of debt and the long-term pain of needing to deal with an economy that's permanently crippled by under-capitalization and deteriation of worker capabilities. They argue that this means fiscal stimulus passes cost-benefit analysis even under very restrained estimates of the fiscal multiplier.

Comments

When Austerity Is Self-Defeating: [N]rmally stimulating the economy with discretionary fiscal policy won't work because the central bank, in order to avoid inflation, will respond to any stimulative impact with higher interest rates. Thus government purchases will "crowd out" private sector activities.... But in a period when rates are up against the zero bound and still the economy is depressed, the calculus is different. By simply committing to keep interest rates low despite the expansion in government debt, the central bank can allow an expansion in government purchases to increase the amount of economic activity and not just crowd out private sector investment.

But what about the need to repay the loan later with taxes? Doesn't that produce growth-slowing distortions? Yes, it does. But they argue that the decision to allow for a very prolonged period of depression also creates economic distortions. For starters, a prolonged recession means a prolonged period of time of below-average investment—a time during which population growth and depreciation mean that a society's stock of capital goods is declining. Secondarily, when people are employed they're constantly learning job-relevant skills whereas when they're unemployed they're slowly un-learning those skills....

Their net point is that rather than a tradeoff between short-term pain and long-term gain, we face a tradeoff between the long-term pain of needing to repay a larger stock of debt and the long-term pain of needing to deal with an economy that's permanently crippled by under-capitalization and deteriation of worker capabilities. They argue that this means fiscal stimulus passes cost-benefit analysis even under very restrained estimates of the fiscal multiplier.